Are Investors Taking Too Much Investment Risk? - Weekly Blog # 713

 

Mike Lipper’s Monday Morning Musings

Are Investors Taking Too Much Investment Risk?

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

One can rarely earn investment gains without taking investment risks. Investors often believe they imperil too much for the risk assumed. This view has led Lee Cooperman to comment that he is a fully invested bear. (He is counting on his timing and trading skills to save his capital) I am in a somewhat similar position in my investment account, which excludes my “burn-rate” and personal future generation endowment accounts.

Focusing on my operating investment accounts I wonder if I am taking too much near-term investment risk, as I do not believe I have sufficient trading skills and expect to be premature. The best way for me to escape a major decline might be to reduce the premature gap from “the top”. The way to do that is to recognize the excessive investment performance achieved by others as a precursor to a massive decline. Prior road trips with a young family echo in my mind, “are we there yet?”.

Listed below are an increasing number of signs of excessive investment performance:

1. Most diversified equity mutual funds produced a 20% gain for 2021, with some professionally managed investment accounts producing returns of 30% or better. History suggests that this is unusual and characteristic of an approaching top.
2. The types of stocks generating above average momentum are like those we have seen in the mid to late stages of a bull market. While stock market cycles and economic cycles don’t have to be coincident, the major ones usually are.
3. The pandemic’s economic cycle impact is unknown. In a normal investment cycle, it would either be the equivalent of an investment “bear market”, or as they say at “the track”, an aberration that should be disregarded. There is reason to disregard the impact of the pandemic, but market leadership does not look like the beginning of a new “bull market”. If we are not in a new bull market, we are in an aging expansion approaching ten years. Bull markets are not closely tied to an economic cycle, but there is something of an echo effect.
4. For some time, the predictive power of reported earnings per share has deteriorated, due to changes in accounting and regulatory rules. From a long-term investment perspective, I prefer to focus on aggregate pretax operating net income, which is not marred by non-operating net interest earnings and changes in share counts. I further attempt to back out the impact of changes in accounting rules, including recognition of depreciation and amortization.
5. We have entered a period of accelerating inflation, which needs to be considered when attempting to predict earnings power generation. This is particularly important in companies reporting significantly larger rises in net income than sales. There are many reasons for this, including operating leverage, with most of the gains coming from the exercise of pricing power to offset inflation. Earnings so generated, are not usually the source of future earnings gains.
6. There are lots of good investment managers, but some with “hot performance numbers” appear to have unsound analytical backing and may be generating gains from skilled market analysis. This is difficult to maintain and is what we used to call “racing luck”.

I am not attempting to precisely predict the future. What I am attempting to do as a good pilot is avoid air pockets that can cause a sudden drop in altitude or permanent loss of capital. 

After The Fall

To the best of my knowledge there has never been an active market that did not have intermittent declines. I therefore have a high level of confidence that at some point there will be future declines in all markets I’m invested in. 

There are two causes for wars, underlying and immediate. Analysts are unlikely to identify immediate causes beforehand but should be able to spot many of the underlying causes. Most of the causes are essentially an ongoing change in the perceived level of competition. When enough power has shifts to one side, the situation is fraught with danger. The leader sees an opportunity to further increase its power and the loser fears further loss of power. Either side may choose to react to this growing disequilibrium. I suggest the growing gap in relative safety measures are such that it is reasonable to fear some unplanned explosions.

 Whatever happens, it is our responsibility as fiduciaries to invest before, during, and after the fall. This plays to our preferred method of investing in stocks, which is through portfolios of mutual funds, mostly somewhat diversified. In preparation for this task, I read the diverse views of successful fund managers. The goal is to build focused portfolio of funds that think differently. This holiday week I had more time than usual to read what managers were thinking about the longer-term future. Two long-term very successful managers produced reports that should earn their place in equity fund portfolios, as described below:

The Capital Group published a 2022 Outlook on the “Long-term perspective on markets and economies”, which had the following highlights:

1. Market leadership is currently the same as it was before the pandemic. (This is an indication of a continuing long bull market)
2. Global economic growth is slowing, particularly in China. (Valuations have expanded, particularly under the influence of buybacks and M&A activity.)
3. Inflation should persist longer than expected, due to broken supply chains, shortages of materials, and more importantly of competent employees, particularly at the trained supervisory level.) Nevertheless, Capital believes inflation will not rise to the double-digit levels of the 1970s. In most inflationary periods stock and bond prices rose.
4. A good time to focus on stock selection by looking for pricing power, sustainable growth, and rising dividends.
5. Expect increased volatility in this midterm election year. (Perhaps this view is best expressed in the firm’s Growth Fund of America, ranked 17th of top 25 mutual funds year to date and the single best for the week ended December 23rd, gaining +3.55% vs +1.25% for the Vanguard 500 index fund. (Compared to many other growth funds, this multimanager vehicle is more risk aware.)

The other fund management group that has produced thoughtful pieces is the London based Marathon Asset Management. They are a successful global investor with a sizable sub-advisor and separate account business in the US. What distinguishes their thinking is their focus on the supply side of the equation, whereas almost all the other investment managers first focus on the changing levels of demand for a company’s products and services. This tends to put them earlier in the timing of the investment cycle. Their portfolios tend to look like those of a value investor, making Marathon a good investment diversifier in an otherwise growth-oriented portfolio. The following are some of their investment ideas:

1. Moody’s and S&P Global are viewed as an oligopoly taking fees for assessing credit instruments. (This is not completely accurate as there are a number of smaller credit tracking agencies, both in the US and elsewhere. What makes them attractive businesses is their ability to access a small increase in prices each year, as well as a fluctuating demand level. (At least I hope so, as both are in accounts I manage, and in a somewhat similar position is Fair Isaac, which provides FICO credit ratings on 99% of US credit securitizations.)
2. With a limited number of new copper mines coming on stream and local governments pushing tax collections, the price of copper is rising. It will probably rise much further as auto production moves to battery electric vehicles (BEV) from internal combustion engines. BEVs, which use roughly 80 lbs. vs 20 lbs. of copper per vehicle.
3. “Private equity will face major headwinds in a governance play with little leverage as topping” (This is another set of headwinds as it is an overcrowded area, with entry prices expected to rise and provisions expected to decline.) “Growth valuations are based on visibility, the ability to push out time horizons ten or twenty years into the future with sufficient certainty to justify paying for that outcome, a very difficult call in a new world based on political whims.”
4. Japan has not adopted the US approach to corporate governance and has limited M&A activity and corporate raids. Stock options are evolving, with more shareholder friendly conditions. (A number of global investors, including Lazard, have a long-term favorable view of Japan, despite its recent economic record. Japan is becoming a more needed US ally, both militarily and economically.)

Next week I hope to devote the blog to some things I and other investors have learned (or relearned) in 2021. Please send me an email on what should be included in the list.    

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Questions Without Answers Indicate Uncertainty - Weekly Blog # 712

 

Mike Lipper’s Monday Morning Musings

Questions Without Answers Indicate Uncertainty

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Searching for Direction

Investors gain confidence when they have a clear sense of direction, particularly regarding short-term market moves. They ask a lot of questions in the hope of finding concrete answers. This is increasingly true as markets move closer to the top of a major phase. Thus, extreme confidence, while generally reassuring, is a warning sign of a nearby top. 

Each week I examine lots of data and articles in the media looking for concrete answers, or at least a guide as to direction. This week I came up with some interesting questions, without any good answers. As many subscribers are professional or insightful individual investors, I will serve up the questions with elements of my indecisive views. I am hopeful some will provide answers as a Christmas present and communicate them to me, either for my personal use or to share.

Are Smarter Investors Calling a Turn?

For some time, I have suggested large investors in the NASDAQ stock market are on average brighter than those invested exclusively or mostly on the New York Stock Exchange (NYSE). This is based on the performance of various small-company mutual fund portfolios trading on the NASDAQ since the March 23, 2020 trough. On average this has been the best performing group based on market capitalization (The other groups are large-caps, multi-caps, and mid-caps.) However, year-to-date smaller caps are running in fourth place. There was possibly a change on Friday with its high volume? The NYSE volume was 5 million shares, split roughly 2 million on the upside and 3 million on the downside. On the NASDAQ, total volume was close to 8 million shares, split 4.6 million shares on the upside and 3.2 million on the downside. The NASDAQ Composite has declined 5.53% from its 2021 peak, the most of the three popular indices and roughly halfway through a classic 10% correction.

Does Friday's market action suggest savvy players picking up bargains at low prices?

Commodity Funds Rising Earlier than Expected

Numerous individual commodities are rising due to shortages. The median commodity fund is up +28.79%, while the weighted average fund is only up +3.92%. The reason for this difference is the extreme performance of Energy funds +71.98% and Precious Metals funds -10.41%. Commodity price cycles typically extend to one or more decades, for example from 1996 to 2016. Professional commodity investors did not expect a general commodity rise for at least another five years, after several new mines became operational. The switch to electric vehicles from internal combustion engine vehicles has accelerated demand for some metals, while the interest in currency coins has simultaneously impacted the demand for numerous commodities.

Are these speculative trends going to continue and cause actual mine and mill openings to accelerate? 

Investors Are Finding Other Markets Attractive 

While the US equity market has gained about 25% year-to-date, three other markets are also up over 20%:  India +22.3%, Taiwan +22.0%, and Canada +21.5%. Many investors now see international diversification as prudent, with political turmoil making US investing difficult for at least the next three years. As the economy recovers from various pandemics and tax/trade uncertainties, declining percentage gains in rising earnings will hurt. 

The Fed is Not Helping 

The Fed is basically defining its role as affirming the current situation by looking forward from its present position.

Critical Question: Do you think you will change your investment strategy materially before the next top?

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Two Contrarian Questions: Next Recession? and Is NASDAQ Leading? - Weekly Blog # 711

Mike Lipper’s Monday Morning Musings

Two Contrarian Questions:

1. Next Recession?

2. Is the NASDAQ Leading?

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Position in Polite Society

In a global society searching for popularity, anyone posing the two blog questions would be labeled a contrarian. That person first needs standing to voice a view significantly different than the commonly believed view. To understand my occasional contrarian views and questions, one should understand their origin and basis.

The Origin of My Contrarian Questions

As with others, I tend to learn more quickly and deeply when my money is at risk. While in grade school and secondary school I was an indifferent student, particularly in precise subjects. Numbers only took on real meaning when I was introduced to the New York racetracks. Suddenly, the eight or nine races a day focused my adolescent attention on statistics and other factors that would lead to losses and gains. I started out behind, as I charged my expenses (going to the track and lunch) to my at-risk budget. After-all, I was going to the track to make money, not for a day in the country or entertainment.

Below, I briefly outline the aspects of what I learned at the track, which have carryover implications for investing:

1. There are too many variables in terms of the number of horses, races, and conditions to be reasonably expert on all. (Screen opportunities to find the best selections)
2. The most popular bets, if won, would at best pay off an equal sized losing bet. Favorites win less than half the time. (Thus, betting only on favorites is a losing proposition)
3. Most bettors have a narrow selection process heavily focused on the most current information, with a home track bias. (More complete analysis often suggests this race is different than the immediate past)
4. Because of the differences in odds, one can finish the day ahead by winning only one of three races. There are also times where one can win more on the second horse at the end than the first. (The correct handling of money can enhance the results, such as weighting the size of bets and paying attention to the probability of results.)

The Next Recession

As someone with a contrarian bent, I believe the next recession is closer than most expect. During the fourth quarter it is common to see projections for the coming year. Most of what I see suggests 2022 will struggle to produce essentially flat results, partially because of the significantly above trend in 2021. Many forecasts do not even mention a recession or suggest a very low chance of one. From the above discussion this prediction sounds like a bet on a favorite, which would be reasonable. But the absence of a discussion on the lengthy period since the 2013 recession is not prudent. Yes, we may be coming out of a downturn in the economy labeled with COVID headlines, but the downturn experienced was not a standard cyclical decline and is therefore outside the history books. Perhaps future historians will label it a recession and take some of the inevitability of recessions off the table for a while.

Throughout recorded history we have regularly had periods of expansion and contraction generated by external and internal causes. External causes usually result from increases in demand caused by new markets or resources. Contractions are mostly caused by over expansion, usually through excessive debt generation. Military and trade wars may start out as expansions but eventually lead to contractions because of the resources wasted in these battles.

Increasing exposure to non-bonded credit is the current flavor of the month in the institutional and high net worth portion of the markets. A decreasing minority of institutions have yet to increase their exposure to “privates” or alternatives. The initiators of these debts are probably raising entry prices while simultaneously lowering safety covenants. At the very same time the Chicago Federal Reserve Bank and the Bloomberg indices of financial conditions are deteriorating. Politicians around the world and around the corner, in governments of all sizes and shapes, are encouraging increased spending, meaning more debt issuance. 

I cannot predict the time when all these trends will create some combination of a recession and or financial crisis, but prudent investors are not currently being offered enough reward to offset the inflation and currency risks.

Is the NASDAQ Leading?

As there are “horses for courses”, there are market conditions favoring one kind of bettor or investor. Part of the problem we analysts face in determining what may happen, is not knowing the individual or institution motivation in buying or selling a security. At best we have “circumstantial evidence”, which can lead us in one direction or the other. 

One of the factors in understanding the strength of various bets at the track is how much they are influenced by hometown biases and similar tie-ins. To some degree I can play a similar game by looking at the differences in trading on the New York Stock Exchange (NYSE) and NASDAQ. Thus far in 2021, the stocks listed on the NASDAQ have produced a higher return than those on the NYSE and Dow Jones Industrial Average. The NASDAQ stocks also led the decline this autumn. 

This Friday was an up day for the market, which highlighted the following similarities and differences in the NYSE and NASDAQ:

                                                                                                   NYSE        NASDAQ

Up Volume                   2.07 mil    2.09 mil

Down Volume                 1.74 mil    2.26 mil

New Lows (% stocks traded)  6.7%        17.1%

Stocks on the NYSE are on average older, larger, and more cyclical than those on the more junior exchange. To my mind there is a meaningful difference in the mix of active traders on the two exchanges. The NYSE is almost completely the home of passive stock index investors, including institutions and investors taking advice from brokers, now styled as wealth managers. By contrast, much of the volume on the NASDAQ is generated by active professional traders. (One of the regular rumors at the racetrack is that the “smart money” is betting on a specific horse, causing the betting odds to drop due to unexpected inflows.) Since NASDAQ prices led on the way up and down, I am wondering whether it is the current home of the “smart money”.

The Value of a Contrarian

I believe the smartest thing I did as Chair of a non-profit investment committee was to mostly limit the membership of the committee to active professional investors. I searched for a bearish investor and was able to get one with a long record of shorting stocks. In most years he was quite successful. He was a great addition to the committee in two ways. First, he questioned many of the buy recommendations from other members of the committee, including its chairman. The questioning led to some recommendations being withdrawn. He also contributed one of our big winners, a company trafficking in a little followed area that was not held in high repute, defaulted residential mortgages. It worked out very well and was a very good diversifier.

A contrarian’s value is enhancing the investment discussion and process. Contrarians do not count their ratio of gains vs loses, but the aggregate sums of money earned vs loses.

Question of the week: Are you getting sufficient contrarian views to help with your decision process?    

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Selections - Weekly Blog # 710

 

Mike Lipper’s Monday Morning Musings

Selections

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Premise

One might say we make lots of selections each day, consciously or otherwise. One of the reasons I rely on lessons from betting at the racetrack is that it forces selection based on known and unknown criteria. The same can be said of investing.  In both cases there are active and passive decisions, although passive passes the decision making onto others. 

In almost all activities, particularly completive activities that can be measured, I try to improve my results by shading the odds a little in my favor. Experience is the best teacher, but each experience should be analyzed. The easy part of the analysis is the number of active participants, locations, length of time, and rewards. What is not easy to determine is the motivation of each participant. A reasonable attempt to figure out motivation is to examine the history of similar activities by participants.

Goals

The strongest of all goals is survival. Survival first requires the preservation of capital by limiting losses and participating in gains. If one wants to grow capital, lost capital must first be made back up to the starting capital level. Actually, return to the original capital level is insufficient, as there are expenses and taxes which reduce initial capital. In today’s world, the appropriate measure of capital is current spending power vs spending power at the beginning. Thus, changes resulting from inflation and foreign exchange need to be calculated and incorporated.

From a Historical Perspective

All life is cyclical. We know our results probably contain ups and downs. Psychologists tell us we normally feel twice as bad about loses than the pleasure of gains. One smart family financial office measures losses, including purchasing power, vs gains achieved. Their goal, which they have achieved, searches for opportunities that will produce gains twice as large as their real adjusted losses. With those concepts as a guide, I first examine the outlook for losses.

Outlook for Three Levels of Losses

Currently, most global stock market indices are showing year-to-date gains. While down from the peak levels of early spring, the gains are greater than those earned in the last two, three, and five years. These gains have been derived from the even larger gains of a small minority of stocks. My guess is non-indexed accounts produced smaller gains. There have been a significant number of absolute losers. The Financial Times recently published an article with the following headline “Half of this year’s blockbuster IPOs are underwater, despite broad stock rally”. They further note, “Goldman has led on 13 deals that raised more than $1 billion this year, but nine of these are now in the red” … ”Six of the 14 deals led by Morgan Stanley were trading below their IPO prices”. I suspect an important portion of these underwritings were bought by hedge funds and other highly sensitive market players. My guess, to the extent possible, is that none of the underwritten shares are currently owned by today’s “fast money” players.

With the above as background, I believe it is wise to look at the three types of market declines:

1. Corrections - Normally a 10% decline from peak. Through Friday, we are about half-way through a standard correction. I always assume the very next day after I purchase a stock there will be a correction. I can therefore tolerate such a market move. 
2. Cyclical – Declines of around 25% occur within each decade, The problem for an investor who pays capital gains taxes out of this account, is the reduction in the size of the account resulting from taxes paid. This raid on capital must be made up to recover the original capital base and is particularly galling if the stock recovers.
3. Structural – Recession/depression with loses exceeding 50%. These are generally part of the economic realization that something is out of order. They often occur during periods of excess borrowing, where the lenders’ financial stability is threatened.

My View

A correction has already begun, and it is not worth repositioning long-term portfolios. We have not had a cyclical decline for a number of years, and it appears to be long overdue. There are increasing numbers of business and people having difficulty. Odds are, within a five-year period there will be a cyclical market decline. Portfolios should be pruned of weak holdings. Weak holdings are those that would cause irreparable pain if they fell by 25% or more before returning to their current level in five years.

Selections Process

This is the topic of a forthcoming speech to a group of financial institutions and their advisers regarding analytical approaches to selecting individual securities, advisers, and funds. Needless to say, my approach is not the standard pitch.

Selecting Individual Securities

Rarely does a person want to exactly copy another. After reviewing the standard Graham & Dodd financial statistics, I focus on what makes a company different. Unless the stock is very cheap compared to peers, it is usually the non-statistical differences which make a stock attractive. I am suggesting that after securities analysis there should be business analysis. The following is a brief business analysis of five stocks owned in accounts, or by me personally. (These are not recommendations for purchase, as that would only be wise if they fit the needs of each portfolio and were priced attractively.)

Apple is viewed as a growing “annuities producer”. Rarely after a single purchase of an Apple product does the customer switch to another brand. Currently, there is a more than usual risk of delayed new purchases due to supply chain issues, higher prices, and the draw of forthcoming new products. Years ago, many General Motors car brands were in a similar position as people in America replaced their cars in one to three years. As with Apple, GM’s strength was in its distribution system. Apple’s is better, having their own stores and departments within big box stores. The annuity like value of their sales helps with their planning and is an attractive attribute for long-term investors. At some point, when attractive new features stop coming, it is possible the annuity like trend will become similar to the overall growth of the market. However, they will continue to produce good sales in countries with faster growing populations.

Berkshire Hathaway is managed for the non-shareholder heirs of current holders. This fits the desires and needs of a large portion of Berkshire’s owners. At some point, I suspect pieces of the operating company will be hived off to shareholders or other operating companies. The book value of these companies starts with their acquisition price, plus earnings less dividends paid to the holding company, which in a number of cases is way below what these activities are worth in an open market. I can envision a day when my grandchildren will receive a growing cash dividend from a smaller, regularly managed company.

Moody’s is a toll collector of fees from most of the world’s fixed income issuing companies, including non-profits and various levels of government. Most of these organizations will grow in an increasingly complex world, where debt is required for progress.

Raymond James Financial has the fastest growing financial services retail distribution network on a per share basis. They aggressively create homes for investment salespeople who find their current employers unattractive.

Goldman Sachs has probably more bright and talented people on a per share basis than any other financial services company. What is intriguing about GS is that it is transitioning from its old model of utilizing borrowed capital to one using capital generated by its own customers. When there is a new profitable game in towns around the world, Goldman will probably be in it. 

Selection of Advisors and Funds

Our history of being an advisor to institutions is one of great length. (We have enjoyed a number of tenures of twenty years or more, which only expired with the change of key members of the investment committee or a desire to go in a different direction). It is disrupting to change critical advisors, so it is done less often. Turnover of a stock portfolio is a more tactical move. With that in mind, the factors to be considered are more about the advisor than the holdings in a portfolio. Portfolios of equity mutual funds change about every 10 years, halfway between the 3-year turnover of a stock manager and the 20 years of a manager of institutional accounts.

In developing approaches to manager selection, one cannot avoid biases. These are thought patterns which at one point had a reasonably good foundation in facts. The intellectually honest advisor consultant or manager should use the current picture to update their biases. The following are my current working biases: 

1. Both highly concentrated portfolios and wide universes can be used successfully.
2. Short investment periods should be examined to find patterns of success.
3. Periods of weaknesses should be discussed in detail to understand humility, blame shifting, and blind spots.
4. Multigenerational team building, by both copying others and new thinking.
5. The reasons for low and high turnover and the difference between turnover of dollars and names.
6. Multiple generations of management in key departments.
7. Business Management skills and controls, analyzing successes and failures.
8. Small vs large losses.
9. Size of boards and executive committees, the smaller the better.

Art Forms

If good investing is an art form, then investment management is a bigger art form. Still larger is the investment management business art form.

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